Market's Downtrodden Made Their Move


For all those stock funds that were beaten down and overlooked in recent years, it was payback time.

In the second quarter, the laggards of the '90s bull market wrested market leadership away from large U.S. growth stock funds, avenging years of frustration--even if only for a while.

"It was a complete reversal of fortune," says Russel Kinnel, head of equities for the publication Morningstar Mutual Funds in Chicago. "All of a sudden you have all these emerging-markets funds, value funds and small-cap funds doing well after being the worst of the lot."

It just goes to show that eventually "everything reverts back to the mean," says Ron Roge, a financial planner in Bohemia, N.Y.

Well, not everything. At least not yet.

Most active fund managers, who themselves have been beaten up over the years for underperforming passively managed index funds, came up short--yet again.

True, the overall statistics say 69% of actively managed U.S. general equity funds did manage to beat the Standard & Poor's 500 index of blue-chip stocks in the quarter, according to research firm Lipper Inc.

There hasn't been a full year in which active managers, on average, beat that index since 1993.

But compared with the more specific category benchmarks, most actively managed U.S. stock funds disappointed again.

For example, Morningstar says only 42% of actively managed funds that invest in large stocks beat the Wilshire 5,000 index of domestic stocks, a benchmark that many pros now believe is a truer standard for large-cap managers than the S&P.;

Only 36% of actively managed small-company stock funds beat the S&P; 600 small-stock index. And only 19% of actively managed funds that invest in medium-sized companies outperformed the S&P; 400 mid-cap index.

The majority of active managers are lagging many of the indexes year to date as well.

"The good news is that most of them [active managers] made money, and most beat the S&P; 500, which will take a lot of the heat off them," says John Rekenthaler, Morningstar's director of research.

"The bad news is, if you look more closely, they still had trouble with their true benchmark and competing against index funds that track them."

It's not surprising that so many active managers have beat the S&P; 500. That index underperformed the other major indexes last quarter. (See bottom of "Stock Fund Performance" table on this page.)

"Up until now, the S&P; 500 has been a difficult benchmark to beat" because the largest companies had for a couple of years been leading the market. That "made active managers look bad," Rekenthaler says. "Now it's an easy benchmark, so it makes active managers look better."

It's also not all that surprising that more active managers didn't beat their appropriate benchmarks for the quarter as well as for the first half of the year, analysts say.

"Indexes look good in strong markets," says Rekenthaler, noting that active managers tend to have a better shot at outperformance when the market is flat or falling, when stock-picking skills matter more.

Indeed, the relatively strong performance of index funds compared with actively managed ones is indicative of how good a quarter and a year this has been so far for equities.

Of the 28 stock fund categories Morningstar tracks, 25 are up year to date, led by Pacific/Asia funds that exclude Japan. These funds soared 38.8% for the first half of the year.

For the three months ended June 30, all 28 stock fund categories tracked by Morningstar saw gains, many of them huge.

Even S&P; 500 index funds, which ranked dead last among all general equity funds for the quarter, according to Lipper, gained about 7% over the last three months. And year to date, they're up 12%, which means the U.S. market is on track for a record fifth consecutive year of 20%-plus gains.

Among the big winners so far this year:

* Value funds of all kinds. "Value investing of all forms came back," says Greg Schultz, principal with Asset Allocation Advisors in Walnut Creek, Calif.

What was the spark? Recent news of improving economic conditions overseas, particularly in Asia, and rising interest rates here at home played a big part in jump-starting the rally, analysts say.

During times of rising economic activity, investors are no longer willing to pay high premiums for big, established growth stocks, since earnings growth is readily available in most sectors, notes Morningstar's Kinnel. Instead, investors are more willing to make bets on out-of-favor sectors. And they tend to refocus their attention on stock fundamentals and valuations.

Which may explain why large value funds, which invest in large-cap stocks with relatively low price-to-earnings ratios, came back into favor in recent months.

For the second quarter, the average large value fund saw gains of 9.4%--more than double the quarterly performance of large-growth stock funds. For the year to date, however, large value funds are trailing large-growth funds.

* Small-company stock funds. For years, small-cap managers have argued that investors looking for deep value need look no further than the small-cap sector.

Starting in April, the market finally began to agree. Small-cap value funds soared 17.9% during the quarter, making this the best-performing domestic fund category.

Thanks to first-quarter losses, however, the average small value fund is up a modest 6.3% year to date, well below the performance of large-cap funds.

* Emerging-markets funds. Perhaps no sector has been as bloodied, or as dismissed, in recent years as emerging markets.

Which is why David Masters, senior analyst with Standard & Poor's Fund Services in New York, says the first-half rally in emerging markets "came as no surprise whatsoever. The only alternative for many of these markets [indexes] was to go down to zero."

For the first half of the year, the typical emerging-markets fund gained 35.1%, versus 10.8% for the typical U.S. stock fund.

The catalyst: The beginning of an economic recovery in battered Asia, and a surge in many Latin American markets after Brazil weathered its January currency devaluation much better than expected.

Masters adds: "A lot of people got carried away in the last 18 months, saying that overseas investing doesn't work and that it's never worked. This proves that that's rubbish."

But not all foreign investing strategies have worked so far this year. After a strong six-year run, funds that invest in Europe have seriously disappointed this year, as economic growth has slowed and the new euro currency plunged.

Europe funds are one of only three stock fund categories--precious metals and health are the others--that have lost money year to date.

Europe's poor returns dragged down the returns on most diversified foreign stock funds, which tend to be heavily invested there. The average foreign fund rose 8.6% in the half.

* Japan funds. Funds that invest in the world's second-largest market had a third consecutive strong quarter, with the typical fund rising 17.8% for the three months ended June 30. The average Japan fund is

up nearly 37% year to date as investors bet that Japan, finally, is on the recovery road.

* Natural resources. As the global economic crisis began to subside during the second quarter, oil prices surged from what had been record lows. That powered natural resources funds to second-quarter gains of 17.3% on average.

* Technology. The Internet bubble didn't burst during the quarter--it gradually deflated. Meanwhile, growth-oriented investors continued to find plenty of other tech stocks to buy.

Result: The typical tech fund gained 14.3% in the quarter and is up 34.4% year to date. Tech funds now rank as the No. 1 fund category over the last 10 years.

* Communications. The average communications fund advanced 12.6% for the quarter as big telecom companies continued to reach out and grab one another, in a merger frenzy.

The average communications fund is now up 27.2% year to date.

A couple of other value sectors--real estate and utilities--also thrived during the quarter, despite their traditional sensitivity to rising interest rates.

Which may be yet another indication that the market during the second quarter was willing to tolerate some risk in its search for value, analysts say.

"It's great that [so many beaten-down sectors] have done so well," says Asset Allocation Advisors' Schultz.

But, he cautions, "it's too soon to tell if it's a fluke or the beginning of a long-term trend."


Stock Fund Performance by Morningstar Category

Beating the S&P;

Most actively managed stock funds have lagged the spectacular performance of the blue-chip Standard & Poor's 500 index over the last five years. But that changed in the second quarter as blue chips struggled while many actively managed funds were helped by a surge in smaller stocks. Percentage of general U.S. stock funds beating the S&P; 500:

1st-quarter 1999: 26%

2nd-quarter 1999: 69%

Source: Lipper Inc., Morningstar

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